Multinational Financial Management Alan Shapiro 7th Edition J.Wiley

1
Multinational Financial Management Alan
Shapiro7th Edition J.Wiley Sons

• Power Points by
• Joseph F. Greco, Ph.D.
• California State University, Fullerton

2
CHAPTER 10

• MEASURING ACCOUNTING EXPOSURE

3
CHAPTER OVERVIEW

• I. ALTERNATIVE MEASURES OF FOREIGN EXCHANGE
  EXPOSURE
• II. ALTERNATIVE CURRENCY TRANSLATION METHODS
• III. STATEMENT OF FINANCIAL
• ACCOUNTING STANDARDS NO.52

4
CHAPTER OVERVIEW (cont)

• IV. TRANSACTION EXPOSURE
• V. DESIGNING A HEDGING STRATEGY
• VI. MANAGING TRANSLATION EXPOSURE
• VII. MANAGING TRANSACTION EXPOSURE

5
PART I. ALTERNATIVE MEASURES OF FOREIGN EXCHANGE
EXPOSURE

• I. ALTERNATIVE MEASURES OF FOREIGN EXCHANGE
  EXPOSURE
• A. Three Types of Exposure
• 1. Accounting Exposure
• when reporting and consolidating
  financial statements requires
  conversion from foreign to local
  currency.

6
ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSURE

• 2. Transaction Exposure
• occurs from changes in the value of foreign
  currency contracts as a result of exchange rate
  changes.

7
ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSURE

• 3. Operating Exposure
• arises because exchange rate
• changes may alter the value of future revenues
  and costs.

8
ALTERNATIVE MEASURES OF FOREIGN EXCHANGE EXPOSURE

• Economic Exposure
• Transaction Operating Exposures

9
PART II. ALTERNATIVE CURRENCY TRANSLATION
METHODS

• I. FOUR METHODS OF TRANSLATION
• A. Current/Noncurrent Method
• 1. Current accounts use current exchange
  rate for conversion.
• 2. Income statement accounts use average
  exchange rate for the period.

10
ALTERNATIVE CURRENCY TRANSLATION METHODS

• B. Monetary/Nonmonetary Method
• 1. Monetary accounts use current rate
• 2. Pertains to
• - cash
• - accounts receivable
• - accounts payable
• - long term debt

11
ALTERNATIVE CURRENCY TRANSLATION METHODS

• 3. Nonmonetary accounts
• - use historical rates
• - Pertains to
• inventory
• fixed assets
• long term investments
• 4. Income statement accounts
• - use average exchange rate for the period.

12
ALTERNATIVE CURRENCY TRANSLATION METHODS

• C. Temporal Method
• 1. Similar to monetary/nonmonetary
• method.
• 2. Uses current method for inventory.

13
ALTERNATIVE CURRENCY TRANSLATION METHODS

• D. Current Rate Method
• all statements use current exchange rate for
  conversions.

14
PART III. STATEMENT OF INANCIAL ACCOUNTING
STANDARDS NO. 52

• I. FASB NO. 52
• A. Dissatisfaction with FASB No. 8
• true profitability often disguised by
• exchange rate volatility.
• B. Balance sheet translation uses current rate
  method.

15
STATEMENT OF INANCIAL ACCOUNTING STANDARDS NO. 52

• C. Income statement uses
• 1. Weighted average rate during period
  or
• 2. The rate in effect when revenue and
  expenses incurred.

16
STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52

• D. Translation Gains or Losses
• 1. Recorded in separate equity account on
  balance sheet.
• 2. Known as cumulative translation
  adjustment account.

17
STATEMENT OF INANCIAL ACCOUNTING STANDARDS NO. 52

• E. New Distinction under FASB No. 52
• functional v. reporting currency
• 1. Functional currency
• for foreign subsidiary the
  currency used in the primary economic
  environment in which it operates.

18
STATEMENT OF INANCIAL ACCOUNTING STANDARDS NO. 52

• 2. Reporting currency
• the currency the parent firm uses to prepare
  its financial statements.

19
STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52

• 3. If foreign subsidiary operations are
  direct extension of parent firm
• e.g. Hong Kong assembly plant which
• sells all its products in the U.S. market.

20
PART IV. TRANSACTION EXPOSURE

• I. WHEN DOES IT OCCUR?
• A. From the time of agreement to time of
• payment.
• B. Arises from possibility of exchange rate
• gains and losses from the transaction.

21
TRANSACTION EXPOSURE

• II. MEASUREMENT
• A. Currency by currency
• B. Equals the difference between
• 1. The contractually-fixed invoice
• amount in a specific currency
• 2. The final payment amount
• denominated in current exchange
• rate for the specific currency.

22
PART V. DESIGNING A HEDGING STRATEGY

• III. DESIGNING A HEDGING STRATEGY
• A. Strategies
• a function of managements
• objectives
• B. Hedgings basic objective
• reduce/eliminate volatility of
• earnings as a result of exchange
• rate changes.

23
DESIGNING A HEDGING STRATEGY

• C. Hedging exchange rate risk
• 1. Costs money
• 2. Should be evaluated as any other
• purchase of insurance.
• 3. Taking advantage of tax
• asymmetries lowers hedging costs.

24
DESIGNING A HEDGING STRATEGY

• D. Centralization v. Decentralization
• 1. Important aspects
• a. Degree of centralization
• b. Responsibility for developing
• c. Implementing the hedging
• strategy.
• 2. Maximum benefits accrue from
• centralizing policy-making, formulation,
  and implementation.

25
PART VI. MANAGING TRANSLATION EXPOSURE

• I. MANAGING TRANSLATION EXPOSURE
• A. 3 Available Methods
• 1. Adjusting fund flows
• altering either the amounts or the
  currencies of the planned cash flows of the
  parent or its subsidiaries to reduce the
  firms local currency accounting exposure.

26
MANAGING TRANSLATION EXPOSURE

• 2. Forward contracts
• reducing a firms translation exposure by
  creating an offsetting asset or liability in
  the foreign currency.

27
MANAGING TRANSLATION EXPOSURE

• 3. Exposure netting
• a. offsetting exposures in one
  currency with exposures in the same
  or another currency
• b. gains and losses on the two
  currency positions will offset each
  other.

28
MANAGING TRANSLATION EXPOSURE

• B. Basic hedging strategy for reducing
  translation exposure
• 1. increasing hard-currency(likely to
  appreciate) assets
• 2. decreasing soft-currency(likely to
  depreciate) assets
• 3. decreasing hard-currency liabilities

29
MANAGING TRANSLATION EXPOSURE

• 4. increasing soft-currency liabilities
• i.e. reduce the level of cash, tighten
  credit terms to decrease accounts
  receivable, increase LC borrowing, delay
  accounts payable, and sell the weak currency
  forward.

30
PART VII. MANAGING TRANSACTION EXPOSURE

• I. METHODS OF HEDGING
• A. Forward market hedge
• B. Money market hedge
• C. Risk shifting
• D. Pricing decision
• E. Exposure netting
• F. Currency risk sharing
• G. Currency collars
• H. Cross-hedging
• I. Foreign currency options

31
MANAGING TRANSACTION EXPOSURE

• Central idea Hedging
• Hedging a particular currency exposure means
  establishing an offsetting currency position
• Whatever is lost or gained on the original
  currency exposure is exactly offset by a
  corresponding foreign exchange gain or loss on
  the currency hedge

32
MANAGING TRANSACTION EXPOSURE

• Managing transaction exposure
• A transaction exposure arises whenever a company
  is committed to a foreign currency-denominated
  transaction.
• Protective measures include using forward
  contracts, price adjustment clauses, currency
  options, and HC invoicing.

33
MANAGING TRANSACTION EXPOSURE

• A. FORWARD MARKET HEDGE
• 1. consists of offsetting
• a. a receivable or payable in a
  foreign currency
• b. using a forward contract
• - to sell or buy that currency
• - at a set delivery date
• - which coincides with receipt of
  the foreign currency.

34
MANAGING TRANSACTION EXPOSURE

• 2. True Cost of Hedging
• a. The opportunity cost depends upon
• future spot rate at settlement
• b. Shown as
• f1 - e1
• e0
• where f1 forward rate
• e0 spot rate
• e1 future spot rate

35
MANAGING TRANSACTION EXPOSURE

• B. MONEY MARKET HEDGE
• 1. Definition
• simultaneous borrowing and lending
  activities in two different currencies to lock
  in the dollar value of a future foreign
  currency cash flow

36
MANAGING TRANSACTION EXPOSURE

• C. RISK SHIFTING
• 1. home currency invoicing
• 2. zero sum game
• 3. common in global business
• 4. firm will invoice exports in strong
  currency, import in weak currency
• 5. Drawback
• it is not possible with informed customers
  or suppliers.

37
MANAGING TRANSACTION EXPOSURE

• D. PRICING DECISIONS
• 1. general roles on credit sales connect
  foreign price to home price using forward
  rate, but not spot rate.
• 2. if the dollar price is high/low enough
  the exporter/importer should follow
  through with the sale.

38
MANAGING TRANSACTION EXPOSURE

• E. EXPOSURE NETTING
• 1. Protection can be gained by selecting
• currencies that minimize exposure
• 2. Netting
• MNC chooses currencies that are not
• perfectly positively correlated.
• 3. Exposure in one currency can be
• offset by the exposure in another.

39
MANAGING TRANSACTION EXPOSURE

• F. CURRENCY RISK SHARING
• 1. Developing a customized hedge contract
• 2. The contract typically takes the form
  of a Price Adjustment Clause, whereby a base
  price is adjusted to reflect certain
  exchange rate changes.

40
MANAGING TRANSACTION EXPOSURE

• F. CURRENCY RISK SHARING (cont)
• 3. Parties would share the currency risk
  beyond a neutral zone of exchange rate
  changes.
• 4. The neutral zone represents the
  currency range in which risk is not shared.

41
MANAGING TRANSACTION EXPOSURE

• G. CURRENCY COLLARS
• 1. Contract bought to protect against
  currency moves outside the neutral zone.
• 2. Firm would convert its foreign
• currency denominated receivable
• at the zone forward rate.

42
MANAGING TRANSACTION EXPOSURE

• H. CROSS-HEDGING
• 1. Often forward contracts not available
• in a certain currency.
• 2. Solution a cross-hedge
• - a forward contract in a related
  currency.
• 3. Correlation between 2 currencies is
• critical to success of this hedge.

43
MANAGING TRANSACTION EXPOSURE

• I. Foreign Currency Options
• When transaction is uncertain, currency options
  are a good hedging tool in situations in which
  the quantity of foreign exchange to be received
  or paid out is uncertain.

44
MANAGING TRANSACTION EXPOSURE

• I. Foreign currency options
• 1. A call option
• is valuable when a firm has offered to buy a
  foreign asset at a fixed foreign currency price
  but is uncertain whether its bid will be
  accepted.

45
MANAGING TRANSACTION EXPOSURE

• 2. The firm can lock in a maximum dollar price
  for its tender offer, while limiting its
  downside risk to the call premium in the event
  its bid is rejected.

46
MANAGING TRANSACTION EXPOSURE

• 3. A put option
• allows the company to insure its profit
  margin against adverse movements in the
  foreign currency while guaranteeing fixed
  prices to foreign customer.